News & Research Archive

The Great Rental Divide: Tech and Conventional Tenants

Jun 23, 2014

Most retail businesses live by the golden rule of thumb for success; if you pay your rent through gross sales within three days of business, then you are doing well. If you are able to pay your rent in one and a half days of business, then you are doing great. But, if it takes your business five days or more to make up rent, then you are going to be out of business. Percentage-wise, many others would say that you are not able to pay more than six to eight percent of gross.

In the Bay Area today, we are facing major rent increases in all aspects of commercial real estate; from offices, to retail, to industrial space. The rent increases go against this traditional rental formula, leaving the real possibility of a wholesale collapse of businesses in the future.

The San Francisco rent is based upon supply and demand. The supply of commercial space throughout San Francisco (and now in a number of regions throughout the Bay Area) is starting to shrink. You may ask, "Why it is shrinking?" It's shrinking on the basis of two industries- the tech and residential industries. The technology field is booming in growth and therefore high-density residential development has been underway to meet this demand.

Both of these growth sectors are intertwined. If you do not have technology growth, then you need to at least have housing growth. If a city does not provide enough housing, it won't have the ability to grow, especially in the technology field where tech talent is not easy to attract.

So why is this a problem and why does the traditional formula of rent not work today? The chief problem is that the technology sector as a whole is not built on profits. Rather, it is built on the hope of the creation of a new concept or service that will lead to profits (in many cases, years from now). In general, technology firms today do not make enough money and in a number of cases, do not even have a product that has developed quickly enough in its early stages to be viable in generating any lasting sales. They are able to thrive because they are backed with serious cash to fund not only their vision, but to also pay rent. Therefore, the traditional rental formula clearly does not apply to them.

However, the conventional businesses are different in that they do rely on sales to pay rent. In which case, the formula above does apply. This is where the "great rent divide" begins to brew. Conventional businesses are enjoying growth as a result of the tech and housing boom. But, as a whole, business is growing in low to mid single digits (not 30% to 60% more) which is what they are facing in rent increases as their current leases start expiring.

An example is this immigration attorney that I am working with. He has been in his same location for over 30 years with a lease that expires at the end of this year. Currently, he is paying $31.00 per square foot and will be looking now at paying rent in the mid to high 50s.

This will be a threat to his business because he will not be able to pass on these increases to his clients because they simply cannot afford to pay more. They will leave him to find a cheaper alternative. We could look at alternative areas to pay less rent, but his business really thrives on the current central location in order to easily commute between the specific courts he must visit daily.

This story is repeated in conversations I have had everyday with my conventional clients. They are "shell shocked" at the rent increases and are really questioning how they will be able to continue to afford their office space.

And yet, we are still seeing a mass amount of speculative money coming in and purchasing office buildings that, in some cases, are trading several times in a single year based on tech firms continuing to flood the market place. These new business owners are also renovating available office spaces in order to meet tech demands of non-conventional offices. Therefore, the stocks of extensive private office spaces are being replaced with wide-open, exposed ceiling spaces.

Retail and industrial spaces are experiencing the same rental increases, all based upon tech demand, not conventional demand.

The challenge will come to a head when the tech boom corrects itself. Only then will prices readjust. Of course, we hope this will be a "soft" adjustment, because anything else could be plummet our local economy.